Question

1. You were hired as a consultant to AICC Company, whose target capital structure calls for 30% debt, 5% preferred, and 65% common equity. The Company’s common stock currently sells at $20 per share and just paid $1 annual dividend per share (D₁). The dividend is expected to grow at a constant rate of 5% a year. (10 pts)

1. Using the DCF model, what is the company’s cost of common equity.

2. If the firm’s beta is 1.2, the risk-free rate ,r_fr , is 5%, and the average return on the market, r_m, is 11%, what will be the firm’s cost of common equity using the CAPM approach?

3. If the cost of debt, r_d, is 8% and the risk premium, RP, is 3%, then what is the cost of common equity using the bond-yield-plus-risk-premium approach.

4. Which cost of equity (r_s) will you be using to calculate the WACC. Hint: the average.

1. If the company’s cost of preferred stock, r_p, is 6% and tax rate is 35%, what is the company’s WACC?

Answer 1

a). Cost of equity (using DCF model) = (D0*(1+g)/P0) + g

where D0 = current dividend = 1; g = growth rate = 5%; P0 = current share price = 20

Cost of equity = (1*(1+5%)/20) + 5% = 10.25%

b). Cost of equity (using CAPM) = risk-free rate + beta*(market return - risk-free return)

= 5% + 1.2*(11%-5%) = 12.20%

c). Cost of equity (using bond yield plus risk premium approach) = yield of the bond + risk premium = 8% + 3% = 11%

d). Cost of equity for calculating the WACC = average of all the three costs calculated above = (10.25%+12.20%+11%)/3 = 11.15%

e). WACC = sum of weighted costs of capital

= weight of equity*cost of equity + weight of preferred stock*cost of preferred stock + weight of debt*cost of debt*(1-Tax rate)

= 65%*11.15% + 5%*6% + 30%*8%*(1-35%) = 9.11%